Eliminating a known unknown of the fiscal policy debate: Firm evidence on tax multipliers

Karel Mertens, Morten O. Ravn 19 June 2012

“There are known unknowns; that is to say there are things that we now know we don’t know”. So said former US defence secretary Donald Rumsfeld. He was talking about the Iraq war but in the debate over fiscal policy, one ‘known unknown’ is the tax multiplier. This column tries to make it a known known.

“[T]here are known knowns; there are things we know that we know. There are known unknowns; that is to say there are things that we now know we don't know. But there are also unknown unknowns – there are things we do not know we don't know.”

Donald Rumsfeld, former United States Secretary of Defense

The Great Recession has spurred a lively debate about fiscal policy. Early contributions to the debate have focused on the effectiveness of fiscal stimuli while more recently the discussion has moved on to issues surrounding fiscal austerity plans (see for instance Corsetti 2012). The relevance of the debate is not hard to appreciate given the depth and duration of the recession that is still gripping large parts of the world economy and the public debt problems that it has triggered in many countries. Only time will tell the longer-term impact of the crisis on the world economy and it therefore remains pertinent to discuss policy issues.

A distinguishing feature of the fiscal policy dispute is the sheer extent to which views apparently differ across economists: During 2009-2010, some commentators argued for expansionary fiscal policies as a powerful remedy for the fall in aggregate activity (e.g. Paul Krugman); others disagreed (Robert Barro). During the Vox austerity debate, J Bradford DeLong and Lawrence Summers have called for continued fiscal stimuli (see DeLong 2012). Alberto Alesina and Francesco Giavazzi, by contrast, argue that fiscal austerity not only is necessary to stabilise public debt but may also stimulate growth if implemented appropriately (see Alesina and Giavazzi 2012).

The range of differing views reflects at least two issues:

The empirical literature on fiscal policy does not speak with one voice;

The current crisis is unusual by nature and there is therefore limited directly relevant empirical evidence available for guiding one’s views about the impact of policy interventions.

The second of these issues, one may reason, can be addressed by using economic theory but even this is difficult given the range of different estimates of key structural parameters that determine the macroeconomic impact of fiscal policies. Whatever the underlying reason for the different views, the level of disagreement is worrying for the credibility of the profession.

Estimating the impact of changes in taxes

In recent work we have investigated the macroeconomic impact of tax policy reforms in normal times. In Mertens and Ravn (2012) we argue that much of the disagreement in the literature about the impact of fiscal policy interventions can be traced to differences in identification approaches.

Identification of structural shocks is very difficult in macroeconomic settings and perhaps particularly so for stabilisation policies since many adjustments of policy instruments reflect either automatic or systematic discretionary policy responses to other shocks to the economy. Take the example of the impact of a change in taxes on tax revenues, output, employment, consumption, etc.

Suppose that lower taxes stimulate output but that, realistically, tax revenues contain an important endogenous component due to tax revenues depending, among other things, on the level of economic activity. One would expect tax revenues to decline when activity declines. Moreover, policymakers may systematically choose to cut tax rates in recessions.

What all this means is that reverse causality is a very serious issue. The positive correlation induced by endogeneity between tax revenues and output could lead one erroneously to conclude that lower taxes produce lower output. Estimation of the impact of a change in taxes requires making identifying assumptions that helps one to distinguish endogenous and exogenous components of tax revenues.

Different approaches to this problem produce widely varying results. Figure 1 shows estimates for post-war US data of the impact of changes in taxes produced by two very well-known studies, Blanchard and Perotti (2002) and Romer and Romer (2010).

Figure 1. Two estimates on the effect of changes in tax

The Blanchard-Perotti figures are average tax multipliers – that is, the changes in output in response to a change in taxes that corresponds to a 1% cut in tax revenues relative to output. The short-run tax multiplier is estimated to be small (0.48 on impact) and reaches a maximum of 1.35 two years after the tax cut. The Romer and Romer figure, meanwhile, looks at the output response to a one percentage point decline in projected tax liabilities relative to output. While the impact effect is similar, the medium-term response is much higher, 2.96% 2.5 years after the tax cut. This is an extremely wide range of estimates for longer horizons.

The two studies referred to above apply very different identification strategies.

Blanchard and Perotti (2002) identify tax shocks in a dynamic setting introducing assumptions about reaction lags and about structural elasticities to identify the tax shocks. They assume that changes in taxes do not affect government spending within a three months window and they calibrate the elasticity of tax revenues to output. The latter parameter is calibrated by combining estimates of the elasticity of tax revenues to changes in the tax base with estimates of the elasticity of the tax base of output.

Romer and Romer (2010) instead used the macroeconomic equivalent of natural experiments, the narrative approach, to identify the tax shock. The narrative approach applied by Romer and Romer (2010) uses estimates from Romer and Romer (2009) to identify an instrument for the structural tax shock derived from tax changes contained in federal tax laws. The endogenous changes in taxes are then separated from the exogenous legislated tax changes by reference to the motivation of their introduction made in official government documents, Presidential speeches etc. The key assumption is that endogenous tax changes were made with a view to return output growth to normal. In the application of the approach to the estimation of the macroeconomic effects of changes in taxes, Romer and Romer (2010) regress variables of interest on the narratively identified tax shock measured as the change in tax liabilities in the quarter of implementation divided by that quarter’s GDP.

In Mertens and Ravn (2012) we assume that the data is generated by a dynamic stochastic process like the one assumed by Blanchard and Perotti (2002) but identification is obtained by exploiting the information contained in the narrative account of Romer and Romer (2010). Differently to Blanchard and Perotti (2002) we estimate rather than calibrate structural parameters such as the tax revenue elasticity to output. In contrast to Romer and Romer (2010), we do not assume that the narratively identified shock is the true structural tax shock but rather that the two are correlated and that the narratively identified shock is orthogonal to other structural shocks. This effectively allows for measurement error in the narrative accounts and corrects for a scaling problem with the narrative which derives from the CBO estimates of the tax liability implications of changes in tax rates which typically assume that the tax base does not respond to changes in tax rates.

Figure 2 illustrates the resulting estimates of the impact of tax shocks when the method is applied to US quarterly data for the sample period 1950Q1-2006Q4. We show average tax rate multiplier estimates. The results indicate much larger tax multipliers than the Blanchard and Perotti (2002) estimates at any forecast horizon and much larger short-run output effects of tax changes than the estimates of Romer and Romer (2010) while the estimates at longer horizons are more similar. Moreover, confidence intervals are sufficiently narrow that short-run tax multipliers below 1 as estimated by the previous literature are not contained in the 95% confidence intervals.

Figure 2. New estimates of the impact of tax shocks

A reconciliation

This shows that the key difference with Blanchard and Perotti’s (2002) estimates are down to the elasticity of tax revenues to output, which these authors calibrate to 2.08 while our estimates imply an elasticity of 3.13. Repeating Blanchard and Perotti’s (2002) estimation procedure with a calibration of this elasticity of 3.13 bring about estimates of tax multipliers that are by all means and purposes identical to our estimates.

Relative to Romer and Romer (2010) our estimator allows for measurement errors in the narrative account which may derive from censoring (exclusion of small tax reforms), classical measurement error, and scaling issues related to the fact that the tax base is assumed unchanged in response to tax changes when measuring the tax liability implications of changes in tax rates. We show that while the Romer and Romer (2009) tax narrative is very informative, the measurement problems cannot be neglected and attenuation accounts for the smaller responses of output to tax changes estimated by Romer and Romer (2010) relative to those produced by our estimator.

Implications for the austerity debate

How do the results above matter for the fiscal policy debate? For one the results show that the short-run effects of changes in taxes can be large, at least judging from US evidence. In Mertens and Ravn (2011) we go further by decomposing the tax changes into personal income taxes and corporate income taxes. We estimate the impact of changes in average personal income taxes and average corporate income taxes using a similar identification strategy to the one discussed above. We find that changes in either type of taxes have large effects on output. However, the impact on tax revenues and other macroeconomic aggregates differ a lot across the taxes. We find that:

Cuts in average personal income taxes stimulate the labour market, private consumption, and investment but also lead to a drop in tax revenues.

Cuts in corporate income taxes instead have little impact on tax revenues but also fail to stimulate the labour market and private sector consumption while they do stimulate investment.

This indicates that care needs to be taken in the design of tax policies. Increases in corporate taxes may not generate much tax revenue but will lower aggregate activity. Increases in personal income taxes can generate tax revenues but this has to be evaluated against the impact on aggregate activity and the labour market.

Our estimates should be seen only as a starting point. They do not necessarily tell us much about tax effects in economic circumstances such as those that characterise today’s world economy with severely depressed goods, labour and property markets and high levels of public debt. Many have argued that these circumstances are key for thinking about the efficacy of fiscal policy interventions and we have no evidence to challenge such views. Moreover, the results refer to the US. There are significant structural differences across countries, which may impact importantly on the efficiency of fiscal policies. Finally, the results cannot be used to make arguments about optimal policies that require estimation of fully structural micro-founded models.

All of these questions are on our future research agenda but we have at least made some progress in the estimation of the impact of tax policies in the US during normal times and therefore contributed to eliminating at least one known unknown.

References

Blanchard, Olivier Jean and Roberto Perotti (2002), “An Empirical Characterization of the Dynamic Effects of Changes in Government Spending and Taxes on Output”, Quarterly Journal of Economics, 117(4):1329-68.